Friday, 11 February 2011

Mervyn King: From Bagehot to Basel, and Back Again

An American friend sent along the New York Times hatchet job on Mervyn King. It is a classic of its genre. The first four sentences include the prejudicial phrases "should command respect", "has been accused", "has been condemned", and "has so far been ignored". Since little appears in the American Pravda by chance, one wonders what and whose agenda is served by such a one-sided and un-journalistic attack on a Governor who has done pretty well in preserving Britain's financial sector, economy and currency when basket cases surround Britain on all sides (westwards not excepted). No one quoted as critical of Mr King in the hatchet piece is a working banker, I note.

This little propaganda reminded me that I wanted to blog one of Mr King's bravest speeches. Perhaps bringing what he said to light will help to explain the animosity of those behind the whisper campaign.

Below are excerpts from a speech Mervyn King gave at the Second Bagehot Lecture Buttonwood Gathering, New York City, October 2010. He had me from the mention of Bagehot in the title, but just the first few paragraphs will tell you why he lost Wall Street and Washington. He directly challenges "extend and pretend" as a solution to the crisis:

Walter Bagehot was a brilliant observer and writer on contemporary economic and financial matters. In his remarkable book Lombard Street, Bagehot brought together his own observations with the analysis of earlier thinkers such as Henry Thornton to provide a critique of central banking as practised by the Bank of England and a manifesto for how central banks could handle financial crises in future by acting as a lender of last resort. The present financial crisis dwarfs any of those witnessed by Bagehot. What lessons can we draw from recent and current experience to update Bagehot’s vision of finance and central banking?

Surely the most important lesson from the financial crisis is the importance of a resilient and robust banking system. The countries most affected by the banking crisis have experienced the worst economic crisis since the 1930s. Output is somewhere between 5% and 10% below where it would have been had there not been a crisis. Unemployment is up, businesses have closed, and the direct and indirect costs to the taxpayer have resulted in fiscal deficits in several countries of over 10% of GDP – the largest peacetime deficits ever.

The Practice of Banking

At the heart of this crisis was the expansion and subsequent contraction of the balance sheet of the banking system. Other parts of the financial system in general functioned normally. . . .

For almost a century after Bagehot wrote Lombard Street, the size of the banking sector in the UK, relative to GDP, was broadly stable at around 50%. But, over the past fifty years, bank balance sheets have grown so fast that today they are over five times annual GDP. The size of the US banking industry has grown from around 20% in Bagehot’s time to around 100% of GDP today. And, until recently, the true scale of balance sheets was understated by these figures because banks were allowed to put exposures to entities such as special purpose vehicles off balance sheet.

Surprisingly, such an extraordinary rate of expansion has been accompanied by increasing concentration: the largest institutions have expanded the most. . .

Bank of America today accounts for the same proportion of the US banking system as all of the top 10 banks put together in 1960. . . .

While banks’ balance sheets have exploded, so have the risks associated with those balance sheets. Bagehot would have been used to banks with leverage ratios (total assets, or liabilities, to capital) of around six to one. But capital ratios have declined and leverage has risen. Immediately prior to the crisis, leverage in the banking system of the industrialised world had increased to astronomical levels. Simple leverage ratios of close to 50 or more could be found in the US, UK, and the continent of Europe, driven in part by the expansion of trading books (Brennan, Haldane and Madouros, 2010).

And banks resorted to using more short-term, wholesale funding. The average maturity of wholesale funding issued by banks has declined by two thirds in the UK and by around three quarters in the US over the past thirty years – at the same time as reliance on wholesale funding has increased. As a result, they have run a higher degree of maturity mismatch between their long-dated assets and short-term funding. To cap it all, they held a lower proportion of liquid assets on their balance sheets, so they were more exposed if some of the short-term funding dried up. . . .

Moreover, the size of the balance sheet is no longer limited by the scale of opportunities to lend to companies or individuals in the real economy. So-called ‘financial engineering’ allows banks to manufacture additional assets without limit. And in the run-up to the crisis, they were aided and abetted in this endeavour by a host of vehicles and funds in the so-called shadow banking system, which in the US grew in gross terms to be larger than the traditional banking sector. . .

The size, concentration and riskiness of banks have increased in an extraordinary fashion and would be unrecognisable to Bagehot. Higher reported rates of return on equity were superficial hallmarks of success. These higher rates of return were required by, and a consequence of, the change in the pattern of banks’ funding with increased leverage and more short-term funding. They did not represent a significant improvement in the overall rate of return on assets. Not merely were banks’ own reported profits exaggerating the contribution of the financial sector to the economy, so were the national accounts. . . .

Moreover, a financial sector that takes on risk with the implicit support of the tax-payer can generate measured value added that reflects not genuine risk-bearing but the upside profits from the implicit subsidy. And even without an implicit subsidy the return to risk-bearing can be mismeasured. It is widely understood that an insurance company should not count as profits the receipt of premia on an insurance policy that will pay out only when a low-frequency event occurs at some point in the future. But part of the value added of the financial sector prior to the crisis reflected temporary profits from taking risk and it was only after September 2008 that much of that so-called economic activity resulted in enormous reported losses by banks.

It is possible to make a very rough estimate of the possible size of this distortion in the reported financial sector output data. If we assume that true labour and capital productivity in the financial services industry grew in line with that in the wider economy in the 10 years prior to the crisis, then, given the inputs of capital and labour over that period, the official estimate might have overstated UK financial sector value added by almost £30 billion up to 2007 – around half of the growth in the official measure. . . .

The theory of banking

It is this structure, in which risky long-term assets are funded by short-term deposits, that makes banks so hazardous. Yet many treat loans to banks as if they were riskless. In isolation, this would be akin to a belief in alchemy – risk-free deposits can never be supported by long-term risky investments in isolation. To work, financial alchemy requires the implicit support of the tax payer. . . .

For all the clever innovation in the financial system, its Achilles heel was, and remains, simply the extraordinary – indeed absurd – levels of leverage represented by a heavy reliance on short-term debt.

Modern financiers are now invoking other dubious claims to resist reforms that might limit the public subsidies they have enjoyed in the past. No one should blame them for that – indeed, we should not expect anything else. . . .
Finding a Solution

The guiding principle of any change should be to ensure that the
costs of maturity transformation – the costs of periodic financial crises – fall on those who enjoy the benefits of maturity transformation – the reduced cost of financial intermediation. All proposals should be evaluated by this simple criterion.

The first, and most obvious, response to the divergence between private benefits and social costs is the imposition of a permanent tax on the activity of maturity transformation to “internalise the externalities”. Such a tax, or levy, has been discussed by the G7, and introduced in the UK. . . .

Why Basel III is not a complete answer

Basel III on its own will not prevent another crisis for a number of reasons.

First, even the new levels of capital are insufficient to prevent another crisis. Calibrating required capital by reference to the losses incurred during the recent crisis takes inadequate account of the benefits to banks of massive government intervention and the implicit guarantee. . . .

One criticism of Basel III with which I have no truck is the length of the transition period. Banks have up to 2019 to adjust fully to the new requirements. Although some of the calculations of the alleged economic cost of higher capital requirements presented by the industry seem to me exaggerated (Institute of International Finance, 2010), I do believe that it is important in the present phase of de-leveraging not to exacerbate the challenge banks face in raising capital today. Banks should take advantage of opportunities to raise loss-absorbing capital, and should recognise the importance of using profits to rebuild capital rather than pay out higher dividends and compensation.

Large Institutions

The implicit subsidy to banks that are perceived as “too important to fail” can be
important to banks of any size but is usually seen as bigger for large institutions for which existing bank resolution procedures either do or could not apply. Moreover, most large complex financial institutions are global – at least in life if not in death. . . .

Solving the “too important to fail” problem will require ultimately that every financial sector entity can be left to fail without risk of threatening the functioning of the economy. . . .
More Radical Reforms

One simple solution, advocated by my colleague David Miles, would be to move to very much higher levels of capital requirements – several orders of magnitude higher. . .

Another avenue of reform is some form of functional separation. The Volcker Rule is one example. Another, more fundamental, example would be to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking (for example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more recently by Kay, 2009). . . .

The advantage of these types of more fundamental proposals is that no tax or capital requirement needs to be calibrated. And if successfully enforced then they certainly would be robust measures. . . .

Of all the many ways of organising banking, the worst is the one we have today.

Conclusion

I have explained the principles on which a successful reform of the system should rest. It is a program that will take many years, if not decades. But, as Bagehot concluded in Lombard Street, “I have written in vain if I require to say now that the problem is delicate, that the solution is varying and difficult, and that the result is inestimable to us all.”

At a time when bankers are keen to supersize bonuses and dividends, based on massively relaxed accounting and transparency standards and a huge public subsidy, Mervyn King reminds us that any so-called "profits" are the result of alchemy that socialises losses to the taxpayers and inflation-hit masses of the world.

He demands more equity capital, no public subsidy, division of systemically important functions from TBTF banks so that they can be left to fail, curbing of dividends while banks rebuild balance sheets and other policies inimical to Wall Street, global banks and their puppets in the Fed.

Assessing Bernanke firm hold on the Fed is also relatively easy. This is the kind of position. IHMO it has been clearly assessed by the US financial blogosphere. Possibly with some kind of negative bias, but one can certainly cope with that.

When it comes to Mervyn King, I am a great fan of his writings and speeches as well. The recent ones at least (was not interested in money before Roubini 2006 caught my attention). His words contrast starkly with the painful academic nonsense that has been spit out at the fed website for years.

However I fail to understand what kind of hold he has on his position. Tolerated as long as he speaks, is the current version of Mervyn King anything more than a late moral justification. A la Volcker, Obama edition?

Just wondering on your views?

Kind regards for this great blog

PS: sorry this is non-native English. Wording may be wrong, inappropriate or tactless at times. Never intentional.

I like it when those in authority formulate their positions on regulations, markets etc.. from the basis of first principles and take a historic perspective.

It makes a welcome change from those that rely on pseudo-theories and lazy arguments based on efficient markets and MPT.

Sadly, many still stick to the latter, though not as fervently as Greenspan did thankfully.

Having said that, if King is a first principles kind a guy in the mold of Hume and Smith, then why was he not more vocal in the go-go years? The tripartite agreement still lives on, surely he should speak out more??

By the way, I think your link is wrong, King's speech should point here:

@ Daniel de ParisI may also be "wrong, inappropriate or tactless at times" but with a much thinner excuse!

@ SidMr King's background is in monetary policy and fiscal policy, and this was his main interest before the financial crisis demanded much more of him.

It is also worth remembering that Gordon Brown had stripped the Bank of its role in prudential supervision of banks, transferring it to the FSA. The Governor might have had criticisms of the adequacy of pre-crisis regulation, but inter-agency diplomacy would have kept him from airing them publicly.

I’ll read MK’s speech later, but on the things the NYT said about him… What’s new!!! Like shock jocks, there are shock journalists. Just like the idiot blooger who trashes something you wrote, (OHHHH it’s so hard to not write back and bash them!!!) you just have to dismiss it as: the other side of whatever argument is being made.

Without up, we’d have no down. Without evil, we’d have no good. With yours (or MK’s ) points, we’d have no counterpoints.

It’s Friday, I’m busy and too tired.

How about something nice for the weekend???

Knowing your appreciation for some similar movies as me (i.e. Zoolander), I’m wondering if you’ve ever gotten to see a little internet movie (Made for youtube) that came out a year or 2 ago?

It’s called “Dr Horrible and the sing along blog”. The super hero themes parallel the economic universe nicely, even though I doubt that was the producers goal (and rather my own interpretation)

Tonight we watch "My Dinner with Andre", which we've been meaning to for some time. Wally Shawn is unlikely to be as funny as Vizzini in the Princess Bride ("never get involved in a land war in Asia"), but should still be excellent.

OK... that was more ballzy then most. I give MK credit for that. ...but that's it.

Fact is, you or I could've written this same speech. Only difference is, we would've written it 3 or 4 years ago. ...and it would've been even harder hitting!

My other trouble is this. ...as much as the "power" has been taken out of his hands, he still wields a big stick, and if I were in his powerless shoes, I would be swinging the everlovingshit out of that stick! He's not.

Like I said, I give him credit for saying things that others in similar shoes are not saying... (which is a sign of a good leader) ...but he can actually do something about it. ...kinda. (which he hasn't, which is the sign of a "GREAT" leader.)

The thing that worries me is that he probably has understood since - oh - 2006 - what has been going wrong, but the fact that it blew up anyway suggests to me that he couldn't actually do anything to stop it. If he couldn't stop it blowing up last time how can we expect him to stop it blowing up again? Anyway, he has always struck me as pathetic when trying to influence events. I have never forgotten his "flat champagne" speech which showed that he could see what was coming - but was afraid to call a spade a spade.www.bankofengland.co.uk/publications/speeches/2007/speech313.pdf

His other speech which I often think about was terrifying. "We cannot afford to allow concerns about sovereign debt to spread into a wider crisis dealing with sovereign debt. Dealing with a banking crisis was bad enough. This would be worse."http://blogs.telegraph.co.uk/finance/edmundconway/100005657/us-faces-same-problems-as-greece-says-bank-of-england/

I don't know if you saw Mervyn King's Wikileaks, but you might find the following posting interesting http://tyillc.blogspot.com/2010/12/mervyn-king-gets-second-chance-to-save.html).

In addition, knowing that you like Bagehot, I thought you might like a little history on the modern US financial system (http://tyillc.blogspot.com/2010/12/disclosure-worked-to-restore-confidence.html).

Finally, the author of the blog does in fact appreciate Bagehot guide to central banking.

London Banker,Very happy to see your posts again. My old Roubini identity was RGE1. On the Cassandra syndrome of seeing the future, but not being able to influence events, what do you think about the internal dialogue at the Open Market Committee? Do you see a true divergence of views among the Regional Bank Presidents and the Board of Governors?

Here in the US the "wealth effect" that Bernanke has conjured is working, for how long this extend and pretend game can last is anyone's guess. A diverse cross-section of people that I have quizzed from the gardener to the billionaire view the economy as on the mend and are generally optimistic to very optimistic. High end real estate, which had been down sharply from 2005 is back to and even exceeding those levels (not so for mid and low end, which continue to struggle, though volume is strong). The purchasers of the high end product are cash buyers with ties to the hedge fund community and Wall Street. There is a buoyancy and upbeat mood that is prevalent throughout the region. Retail is booming with restaurants packed and parking lots full.

The media/Pravda are party to this economic euphoria that we are back to the good old days and the 'consumers' of that media are 'buying' it.

The public/taxpayers who are footing the bill are seeing more positives than negatives, notwithstanding food and energy inflation that is starting to emerge. Bernanke, Geithner and their media mouthpieces have done a masterful job of convincing many Americans that the end of the journey to Recoveryville is just around the next corner.

thanks for this. i was aware mervyn king's contribution to understanding the malaise was greater than america's dearly beloved bernank. but i did not realize how clear-sighted, realistic and pragmatic his vision was. he is the kind of fellow who should be involved in monetary policy, and his words and those of bagehot are useful to me to say the very least.

LBAs to Mervyn King. Let me begin by stating clearly that in my opinion he could and or does clearly understand the issues, but fails to use his influence to bring about what is required. IOW (and I believe I posted something like this at the time) he neglects his duty to humanity. No courage of conviction here but full marks for the superficial understanding. IOW no cigar.

Also, as another example of the same argument, Axel Weber as well as Peer Steinbrueck have just withdrawn themselves from the position now occupied by Jean Claude Trichet. They both disagree with the consensus of the ringed wagons surrounding. Its' abck to the Cave for these folk. Hence, it can be and will be just more of the same.

Economic-theory: "The economists, like the teacher, have never studied deep enough to discover that this science is not governed by the laws of “chance” but by principles which are as fixed and unchangeable as those by principles govern any branch of mathematics." Mary E. Hobart. She essentially says, economists just "guess-it".

As you are aware, my position on economics from the Roubini days, is that economics is a faith-based belief system which refuses to be scrutinized by the established and rigorous processes of scientific inquiry and criteria and as a consequence is applied through any particular opinion that has the most powerful lobby being applied at any particular time. The obvious outcome of this, supported by King's paper, is the resultant symbiotic relationship built between banker and government where, the banker, a priori, becomes the senior partner and government dutifully legislate to minimize all the risk by transfer to the taxpayer.

Happy to see you Blog - I see it is getting some attention in the USA (Yves Smith).

@ Anon 11:26Thanks for the Wikileaks cable link. I had not read that before, but it substantiates that King grasps the essential problem as excessive leverage and undercapitalisation of the banking sector. As he favours reduced leverage and much, much greater capitalisation, his peers across the Atlantic will have been displeased with his agenda.

As for full disclosure, I agree that this would stabilse the system and purge the excesses, but that is what TPTB will not allow. Sadly, transparency and market pricing are essential to efficient financial intermediation and a healthy capitalist economy. Since "extend and pretend" is the preferred policy, we can expect less transparency, less efficiency and more government intervention in markets - possibly quite oppressive intervention.

@ Zaydac and PeterJB

I think it unfair to castigate Mervyn King for failing to stop the crisis in advance, as he did not have the authority to intervene in 2006 or 2007. Gordon Brown stripped the Bank of England of its role in prudential supervision, transferring it to the Financial Services Authority. The Bank could not have ordered higher capital standards, imposed greater transparency, or limited excessive speculation and reliance on short term finance, as these are all under the FSA's authority. The regulatory and policy failures are theirs alone.

By way of illustrating the banks' capture of the FSA, at one point the executive director of the International Swaps and Dirivatives Association was put in charge of wholesale market supervision leading to wholesale ill-transparency, forbearance and excess.

When the crisis hit, the Bank's financial stability remit came into force and it handled the situation very deftly. Now that the FSA is to be reformed under the Bank, we shall have to see how policies on capitalisation, transparency, leverage and other matters proceed from here.

@HMSVGood to see you here - back among friends. When Marriner Eccles reformed the Federal Reserve in 1934 he expressly wished to devolve power from New York to the regional banks and to independent governors in Washington. That worked pretty well until the progessive regulatory capture of the past 25 years. Now the regional Federal Reserve banks have a clearer picture of the causes and implications of the failures for their districts and their own member banks, and are asserting themselves more. This is the way the system is supposed to work for the Fed. Geithner at Treasury may tip the balance back in favour of Wall Street, but at least the regional banks are beginning to be heard.

@ HayesPeople always feel rich when spending borrowed money. They only feel poor when forced to pay it back out of income.

"I think it unfair to castigate Mervyn King for failing to stop the crisis in advance"

'castigate' is a mite strong - and I certainly wasn't expecting him to stop anything in advance.

But, from his papers, I get the impression that he knows that the banking system needs reform and if he didn't I would expect him to resign. It was obvious in the mid 1990's that the major European Banks were all mostly technical bankrupt: ever I knew this, although I had some inside information (I posted comments about this at RGE). Why don't people stand up and be counted - is it because they are afraid? That is, afraid of being assassinated? If they are not then they are stupid!

But someone in King's position could use his influence and obvious considerable intellect even if he lives in fear of morons such as Blair and 'Brown the challenged".

Look at Assange - and he is still alive and is a nobody! Imagine if he had a few friends? Imagine if he had Kings influence, and inside track? Is it too much to ask, to commit to humanity when you know how it is going to end? For the one's who are effectively innocent?

Or do we just let it burn down and then some lick-spittle who has an audience stands up and says, nobody could have known it would end like this... ugh blah blah?

when do we make a stand? Murabak runs with US#70Billion?? It's ok, he was a nice guy..

Every US war is illegal - never mind George W Bush was a nice guy, like Tony Blair...

Regional Presidents talk directly with people in business and the Fed Board's contact is much more limited to economists and people who have an indirect experience of what is happening in the field. By Geithner I assume you mean the NY Fed (Dudley), yes certainly tips more weight to Wall Street. I can't stress enough the sense in meetings of this nature the pervasive fear of being wrong as opposed to expressing a true,unique point of view. The ideas often coalesce around a safer view based on what is clearly happening at the moment. It is very difficult to express a view that is substantively different than what the general concensus is and even more difficult to have others back that opinion. For decision makers who are often removed from real world interactions, it is very difficult to tell the difference between noise and signal, and very easy to suppress your own feelings of unease.

I served with Paul Fisher, I knew Paul Fisher, Paul Fisher was a friend of mine. LB, you’re no Paul Fisher!

Ha… Couldn’t help but throw out a little Llyod Benson.

While playing the “who am I” game, I would like to throw out (as I have in the past) that LB is neither “London” nor “Banker”.

Instead LB is the demon child of Alan Greenspan and Jonas Salk, and was not gestated in the womb, but rather in a moldy federal reserve safe deposit box. LB is now the cure to a polio stricken monitary policy, whose computer virus has outpaced even Bill Gates vaccinated windows shots. LB now flies the globe in a money suit, made purely of unified currancies sewn together by love.

Thanks for the Wikileaks cable link. I had not read that before, but it substantiates that King grasps the essential problem as excessive leverage and undercapitalisation of the banking sector. As he favours reduced leverage and much, much greater capitalisation, his peers across the Atlantic will have been displeased with his agenda.

It turns out that the bankers have been very active in making sure that King's plans for greater capitalization do not amount to anything. (see http://tyillc.blogspot.com/2011/02/does-banking-industry-have-too-much.html)

Jamie Dimon feels that the US banking system will have too much capital in a year.

The Treasury and Fed are about to say that the US TBTF have adequate capital and can start paying dividends again.

UK banks will take the US bank capital levels as the maximum if there is to be a level playing field.

This effectively ends King's bid for more capital.

I only wish he had chosen to fight the transparency fight with the TBTF.

It seems that the bankers (and "industry") have convinced "leadership" that they are collectively "all" under threat from King's little speech and opines. It seems that I was wrong about him putting his head on the guillotine rest but I am pleased to be so, as it restores a little faith I had in this man.

But the hyena will now surely succeed in having his bones bleaching on the jungle floor. The game is afoot.

"The name 'London Banker' had especially a charmed value. He was supposed to represent, and often did represent, a certain union of pecuniary sagacity and educated refinement which was scarcely to be found in any other part of society."